The Unavoidable Hurdle to Monumental Wealth

We all want to get rich from our investments. As the past year has shown, however, those gains don't come for free. To reap the profits of investing, you have to get comfortable with risk.

But when the market seems to move hundreds of points up and down every day, how can you avoid feeling like you're in way over your head? History can teach us valuable lessons. But to come up with a personal solution to the risk question, you also have to look at your own investing personality.

The new paradigm of risk
This bear market has blown away many of our preconceived notions of stock market risk. Consider: It's been 75 years since the S&P 500 was down as much in a single year as it is so far this year. Even during historically bad periods -- the oil crisis of the 1970s, the 1987 market crash, and the tech bust earlier this decade -- the market's drops didn't come as quickly as they have in 2008.

As a result, many rules of thumb about risk have proved completely inadequate this year. In the past, if you'd said you were willing to see your portfolio lose a third of its value in a single year, some risk questionnaires would have told you to invest 100% of your money in stocks. Yet the year's losses so far -- 38% to date for the S&P, after a rally from levels that had the market down nearly 50% -- easily eclipse that tolerance for risk.

In other words, no matter what people thought, few were really prepared to see stocks fall as much as they have.

It's all up to you
But as important as history and statistics are, they don't really determine your own personal risk tolerance. For insight on that, you have to look at your own reactions to this bear market.

For instance, one person I talk with a lot on the Fool's discussion boards decided last week that she had reached her breaking point. She wasn't sleeping, and every new piece of bad news made her fear for her retirement savings. So she sold off a significant chunk of her stock portfolio. Even though she believed in the long-term prospects for many of the companies, it couldn't fix how scared she felt right now.

If that's the reaction you're having, then it doesn't matter what history says: You took on too much risk in your portfolio. And unfortunately, now isn't the best time to find out that you're uncomfortable with risk. But with the market up roughly 20% from November's lows, it's not the worst time, either.

Here are four tips to get your risk levels where you want them.   

  • Understand your stocks. Here at the Fool, we strongly believe that it's not enough to know what to invest in; you also need to know why. So for instance, if you don't understand the first thing about how biotech companies work, don't put your money into Genentech (NYSE: DNA  ) or Myriad Genetics (Nasdaq: MYGN  ) -- even if they're outperforming the rest of the market.
  • Even "safe" stocks fall. One of the toughest things about 2008 is how even the mighty have fallen. Most investors would have put Boeing (NYSE: BA  ) and Bank of America (NYSE: BAC  ) among the most secure blue-chip names several years ago, yet each has lost 50% or more of its value in the past year. So don't assume that what you own is completely safe -- no matter how well known your stocks are.
  • Diversify. We've learned this year that when everything's down, it's tough to avoid losing money. But holding a diversified portfolio of stocks is still less risky than going all-in on one particular sector. Sure, with perfect foresight, you could've picked companies such as Family Dollar (NYSE: FDO  ) and Dollar Tree (Nasdaq: DLTR  ) , whose businesses benefited when customers became more bargain-conscious. Yet when the economy recovers, another group will probably take their place at the top. Being diversified increases the chances that you'll own some of the winners no matter who they are.
  • Get paid. When you're not sure how a company will perform, demand some income -- in the form of dividends. When tough times hit the economy, a company like General Electric (NYSE: GE  ) will inevitably suffer -- but that company's commitment to paying dividends means that shareholders will at least get something back every quarter.

Don't expect to master risk -- it takes nerves of steel not to get scared in markets like this. But once you grasp your own portfolio's true risk, you'll be in a better position to control it -- and to avoid panicking at exactly the wrong time.

For more on investing in a tough market:

Motley Fool co-founders David and Tom Gardner believe in the power of knowledge. That's why in their Motley Fool Stock Advisor newsletter service, you won't just find picks -- you'll also get the detailed analysis and reasoning that's behind every stock recommendation they make. See for yourself -- it's free with a 30-day trial.

Fool contributor Dan Caplinger has learned to love risk. He owns shares of GE. Bank of America is a Motley Fool Income Investor pick. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy isn't risky at all.


Read/Post Comments (5) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 09, 2008, at 12:57 PM, trurl9 wrote:

    Since banks don't pay decent interest rates on savings accounts, many who are risk averse fear they have to buy stocks and bonds to outpace inflation. Many fail to invest only money they can afford to lose. Most of us can not afford to lose money, but where else can we earn a decent return on savings?

  • Report this Comment On December 09, 2008, at 1:34 PM, NightBengal wrote:

    trurl9 poses a very good question. My guess would be CDs, if the money was not needed right away. Then again, if you truly can't afford to lose it, even that time horizon may be too long.

    The Fed has been punishing savers for the past eight years. It's hard to find a safe haven with an adequate time horizon, especially now.

  • Report this Comment On December 09, 2008, at 5:03 PM, kamuirei wrote:

    trul9 makes a very good point. My fiance views the stock market almost like gambling. At the same time she's getting .10% on her savings account.

    I'm reasonably happy with my real life setup:

    Checking: Charles Schwab Checking (no fee, repays your atm fees monthly, free checks, free bill pay, no fee for transactions in foreign currencies, no minimum if you link it to a brokerage with them 1.50%)

    E*Trade savings (no minimums, no fees, 3.30%)

    (In better times these accounts were paying 4% and 5.05% respectively. Transferring funds between the two honestly takes about a week, but it's easy to setup through either bank. It doesn't beat bonds, but for day to day and money you need within the year these seem to do the job nicely)

    Emergency Fund (within 5 years) DBIRX which is available without transaction fees through the Schwab brokerage. 5 star fund, .15% fee, Pretax: 10 year - 5.14%, 1 year - 2.47%.

    Can someone explain to me why the share price of this fund seems to be far more consistent than most of its peers in recent months?

    Conservative ETF wise: One of my holdings is SDY. Despite it's high (40%!) allocation to financials, it's down half as much as the broader market. It's yielding nearly 5% right now with quarterly distributions.

    Aggressive ETF wise: IJS, IWS, VEU and I'm intrigued by DWX due to its sector/country caps (which are the reasons I shy away from PID) however its volume is miserable.

    -----------------------------------------------------

    Somewhat related:

    E*Trade tends to have higher rates on CDs than Schwab.

    Schwab has a credit card that is 2% cashback on everything (no limit to cashback, automatically contributed to brokerage monthly) although I've been quite happy with the older version of Chase Freedom.

  • Report this Comment On December 09, 2008, at 5:23 PM, koolguyme wrote:

    Kamuirei,

    Thanks for all that info. But frankly speaking, even getting 5% return on your money may be just enough to fight inflation.

    If the inflation is more than that (like it has been in the past), then your money is still losing value.

    Here is the link for the past average inflation.

    http://inflationdata.com/Inflation/images/charts/Articles/De...

    Currently, inflation is at 3.5%, but I highly doubt it will stay at that level, with the Fed printing presses operating extra time.

  • Report this Comment On December 09, 2008, at 5:51 PM, kamuirei wrote:

    Yes, and that's why only money I need within the next year is in cash and the next 5 years is in bonds. The goal of those assets is to minimize the effect of inflation and maintain purchasing power, not capital appreciation.

    Beyond that I'm 100% stock, and primarily small/mid value and international stocks. The historical return of those categories is far far higher.... as is the volatility, making them unsuitable for short term assets.

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